High-level performance numbers like IRR and TVPI tell you whether or not a manager has performed well in the past, but the real key is to understand how they generated that value in their portfolio companies and how this compares with their proposed strategy for the new fund
One of the commonly used methodologies is to calculate a Value Creation Bridge like the below graph shows. A visual representation of where value was added by a manager. This will allow you to quickly identify how factors such as currency impacted performance, and whether a manger focused on growing revenues or improving profits to warrant the sale cost.
Understanding a manager’s likelihood of repeating success can also be gained by analysing the spread of their portfolio companies performance – were there one or two deals that carried the rest of the portfolio? Or was performance outstanding in a certain sector or geography, with the rest lacking? Identifying any outliers and filtering them out of a track record is a useful way to understand how performance may have looked without them, and could look in the future if they followed the same strategy.
It is important to remember that the success of a private equity fund manager relies heavily on the individuals within the deal team. So it only makes sense that you would want to understand who was leading winning (and losing) deals and their role in the upcoming fund.
This helps you identify questions to pose to the manager: If there is a star performer leading all the top deals, what risks do the fund and your capital incur if he leave? Getting to the bottom of these questions then helps you negotiate better when drafting investment terms for the Limited Partnership Agreement.
Investors who are required to select and monitor investment managers should develop a basic understanding of investment statistics. Quantitative tools can provide you with good insight that you can use in your qualitative interviews with managers and when monitoring your investments.